There are certain industries were achieving sustainable economic returns and steady equity appreciation is nearly impossible, and rail car manufacturing seems to be one of them. Among the major manufacturers, a list that includes Greenbrier (NYSE:GBX), Trinity Industries (NYSE:TRN), American Railcar (Nasdaq:ARII) and FreightCar (Nasdaq:RAIL), two straight years of double-digit operating margins and/or return on invested capital is exceedingly rare.
With that in mind, investors would probably do well to approach Greenbrier with caution. While the company's move into tank car manufacturing should lead to higher revenue as crude oil producers turn to rails to move their product, the company has its work cut out to improve long-term margins and returns on capital. Although there could still be a trading opportunity in these shares, investors considering a long-term commitment should take a long look at the very poor historical industry returns.
Unimpressive Numbers For Fiscal Q2
While Greenbrier was arguably right to rebuff Ichan's bid for the company back in December, the reality is that this is a company that remains challenged by its initiatives to expand capacity, grow deliveries, and improve margins.
Revenue fell 8% this quarter and came in about 5% shy of expectations. Manufacturing revenue fell 8% from the year-ago period, which isn't so bad in the context of a 27% decline in unit deliveries. At the same time, though, revenue from the wheel services business declined 7% and leasing revenue fell 5%.
Margins remain a talking point, and not in a good way. Overall gross margin actually improved from the year-ago level (by about 20bp), as the manufacturing margin improved 150bp. Unfortunately, the margin in the wheel service business declined significantly, down more than three points. While reported operating income fell about 10%, adjusted operating income (factoring out equipment sales) fell 12% and while the company basically met most analysts' expectations for margins, it did represent a 30bp year-on-year decline.
Orders Look Robust, But Will They Be Profitable?
Fiscal year to date, Greenbrier has booked orders for 9,600 cars worth just over $1 billion, bringing the backlog up to 11,700 units worth $1.3 billion. While the company has tried to keep some balance in the order book, more than 40% of the orders have been for tank cars and another 20% for auto cars.
While a robust backlog is a good thing normally, I do wonder about the profitability of these orders. Traditionally Greenbrier has been stronger in double-stack intermodal cars, with companies like American Railcar and Berkshire Hathaway's (NYSE:BRK-A,BRK-B) Union Tank holding more share in tank cars. Though I understand the company's desire to enter this fast-growing and high-margin business (which has been kickstarted by the development of oil fields like the Bakken), I do wonder about the margin implications of shifting the production mix, as this isn't a company with a great history of margins to begin with.
In any case, management is at least saying the right things today. The company is looking to boost gross margin by at least two full points through efficiency initiatives and the transfer of more production to lower-cost areas like Mexico. At the same time, the underperforming Wheel Services business is now up for sale and that should help improve margins while also bringing some liquidity into the capital structure.
SEE: Evaluating A Company's Capital Structure
The Bottom Line
Between tank cars, auto carriers, and intermodal cars, Greenbrier is heavily involved in the best-growing categories of rail traffic today. That said, this is still a rail car manufacturer, and the history of this sector is pretty clear – while there are periodic good times, they never last and long-term returns can be elusive. Maybe this time is different. Maybe demand from customers like Union Pacific (NYSE:UNP) and General Electric (NYSE:GE) will prove more sustainable and maybe the company's margin improvement efforts will bear fruit. I acknowledge the possibility, but I don't like investing in “maybe”.
SEE: Investment Valuation Ratios: Enterprise Value Multiple
Looking at valuation, there's a familiar dichotomy. On a cash flow basis, this looks like a miserable stock. Then again, these stocks seldom trade on the basis of cash flow, and the stock does look perhaps 10% undervalued on an EV/EBITDA basis (7x calendarized 2013 EBITDA). I won't discount the possibility of another bid from Ichan and/or even more orders (or a successful sale of Wheel Services), but buying a volatile stock with weak returns on capital when the markets are near multi-year highs seems like a bad idea to me.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.